By
Tom Dyson, publisher, The Palm Beach Letter
Monday, November 30, 2009
It's a terrible time to be an income investor...
The Fed has pushed interest rates to the lowest levels in history. Money market funds pay nothing. Your bank account pays nothing. Treasury bills pay nothing. Even if you decide to take more risk and buy a long-term Treasury, you'll still make less than 4%.
Municipal bonds are trading close to 40-year lows. The dividend yield on stocks is terrible... at 2.2% for the S&P 500. Even my favorite pipeline investments now yield less than 8%.
To top it all off, most income investments have enjoyed a huge bounce in the stock and bond markets this year. In short, chasing yield in this environment is a risky game and it's likely to end in an accident.
Covered call income is unique in the world of finance. It's the only way I know to earn a high yield, without taking a flyer on some issuer's ability to pay you back. With all the risk in the credit markets right now, earning income this way is an incredibly useful strategy.
So how does it work?
Essentially, you sell the future upside in a stock position you own to another investor in return for a cash payment today. It's incredibly simple...
There are two parts to a covered call trade. First, you buy a stock. Then, you sell a call option against that stock. You receive a premium for selling the call option. In return, you promise to sell your stock if it rises past a certain price in the future.
Last year, we earned income this way from blue-chip stocks. Volatility peaked in November 2008, when the credit markets were broken and the future was uncertain. The S&P 500 had fallen over 50% at that point. It was the perfect time to use the covered call strategy. We were able to sell the most expensive options in history and protect our downside with stocks at decade lows. We made more than 40% on safe stocks like Coca-Cola and Intel in one year.
The problem is, covered call writing on blue-chip stocks is not a slam dunk like it was months ago. Option prices are down 78% from their peak in 2008, seriously hurting our potential income stream. Meanwhile, the stock market has rallied 70% in nine months. Signs of weakness are starting to appear. Former market leader Goldman Sachs just hit a two and a half month low. As my colleague Brian Hunt has shown, there is no buying power behind market rallies any more.
If you think stocks are set for a period of profit-taking weakness like I do, here's a unique covered call strategy to consider: writing covered call options on "inverse" exchange-traded funds (ETFs).
Inverse ETFs are investment funds set up to move in the opposite direction of conventional stocks and ETFs. Take the inverse China ETF (FXP) for example. It is structured to return double the inverse of the major China ETF (FXI). Or the inverse financial ETF (SKF). It is set up to return double the inverse of a bank stock index. (Due to the imperfect way they are set up, these funds don't perfectly mirror regular returns. But over the short term, they get close.)
SKF falls when the bank stocks rise. It rises when bank stocks fall. Right now, SKF is cheap, having fallen from more than $200 a share to $24. Meanwhile, there's plenty of volatility in the stock price. Right now, SKF trades for $24.50. You can buy a batch of shares and sell January $26 call options on the position for $1.41. That's a 5.7% instant payment on your ETF... for just two months. And you get to keep a little bit of upside.
Selling covered calls on SKF makes money as long as bank stocks don't soar and send SKF down in value. It makes money if bank stocks trade sideways or decline a bit.
I don't recommend this sort of "income trading" to most investors. It requires a good sense of timing. It requires you to be handy with options. But conventional income investing just isn't paying off right now. If you're comfortable with doing a little extra work, consider the strategy above.
Good investing,
Tom Dyson
P.S. If you're interested in these unique "income trading" ideas – or more conventional income producers like pipeline stocks and bonds – consider taking a trial subscription to The 12% Letter. You can learn more about a subscription here.
Goldcorp (GG)... gold
Royal Gold (RGLD)... gold
Barrick Gold (ABX)... gold
Yamana Gold (AUY)... gold
Newmont Mining (NEM)... gold
Keegan Resources (KGN)... gold
Silvercorp (SVM)... silver
Hecla Mining (HL)... silver
Silver Wheaton (SLW)... silver
Chevron (CVX)... Big Oil
Statoil ASA (STO)... Big Oil
Duke Energy (DUK)... utility
Syngenta (SYT)... agriculture
Starbucks (SBUX)... coffee shops
Google (GOOG)... search engine
Best Buy (BBY)... electronics retailer
Dillard's (DDS)... department stores
Deere & Co (DE)... farm & construction equipment
U.S. Global Investors (GROW)... asset manager
Freeport-McMoRan (FCX)... major juice!
Intuitive Surgical (ISRG)... robotic surgery
Pfizer (PFE)... Big Pharma
Novartis (NVS)... Big Pharma
NEW LOWS OF NOTE LAST WEEK
Severn Bancorp (SVBI)... bank
Mid Penn Bancorp (MPB)... bank
Smithtown Bancorp (SMTB)... bank
Citizens & Northern (CZNC)... bank
First Commonwealth Financial (FCF).. bank
Indiana Community Bancorp (INCB)... bank
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